Concession Crazy

Not so long ago, landlords enjoyed the luxury of choosing tenants. In a reversal of fortune, tenants have put the squeeze on landlords. Torto Wheaton Research reports that the national office vacancy rate hovers at an unhealthy 15%. Absorption, an important barometer of leasing activity, has averaged a negative 5% over the last year, but that's an improvement of about five basis points over 2001.

Still, tenants have pushed down effective gross rents 23% nationally, to roughly $33.50 a sq. ft. for Class-A space since their peak in early 2000, according to Grubb & Ellis.

Against that backdrop, landlord concessions vary from market to market, but in one form or another they're becoming standard boilerplate in lease documents. Generally, they include more tenant improvement dollars and free rent.

In New York, landlords are paying up to $50 per sq. ft. for tenant improvements, double the amount of only a few years ago. Landlords are even paying $2 to $5 per sq. ft. for engineering and architectural services related to space build-outs, a practice unheard of a few years ago, says Robert Lowe, executive director at Cushman & Wakefield.

Office REIT Occupancies 2002-2003

REIT

1Q 2002

1Q 2003

Change

Equity Office Properties

90.7%

87.2%

-3.9%

CarrAmerica Realty

93.9%

90.4%

-3.7%

Trizec Properties

90.0%

87.0%

-3.3%

Boston Properties*

95.1%

93.0%

-2.2%

Arden Realty

91.0%

89.7%

-1.4%

Mack-Cali Realty*

93.9%

92.4%

-0.64%

*includes some industrial space.

Source: Company reports

In the Dallas/Ft. Worth market, landlords are willing to provide up to 14 months of free rent on a five-year lease. Still, they refuse to increase tenant improvement dollars past $25 per sq. ft., says Stephannie Mower, president and COO of the asset services group for The Woodmont Co., which manages about 2 million sq. ft. of offices in the Dallas/Fort Worth area.

Whether landlords can hold the line on tenant improvement dollars is unclear. The market posted a 25% vacancy rate in the first quarter of 2003, up from 24% the same period a year ago, according to Grubb & Ellis.

“Owners will do whatever it takes right now to increase occupancy,” says Jana Turner, president and COO of asset services for CB Richard Ellis. In some of the toughest markets, that means accepting money-losing deals and leases where operating expenses and concessions cost landlords more than they're getting.

Wall Street Weighs In

Wall Street analysts broached the subject of money-losing leases during office REITs' first-quarter earnings calls. REIT executives say they're resisting such deals and instead are banking on seeing at least a sign of rent stabilization later this year. Until then, REITs may continue to fall. In the first quarter, expiring leases at Equity Office Properties (EOP) averaged $29.35 per sq. ft., but the average price of renewals and new leases was $25.53. That represents a 13% drop, due in part to some $20.5 million in free rent.

Other landlords, especially in older buildings, don't have the luxury to reject leases that aren't performing well. Tenants upgrading from Class-B and Class-C buildings are driving most of what little leasing activity exists. Consequently, landlords of those buildings face a dilemma: refuse a money-losing deal and eat the operating expenses of the vacant space with the hope that better days are just ahead; or accept the lease to help offset operating expenses and gain a potential renewal later. The risk hinges on locking into a bad deal on the eve of stabilizing rents.

“That's the tension that's created in a market that has gone so far south,” says Mark Best, senior vice president with Lowe Enterprises, a Los Angeles-based investment advisory firm that manages about 10 million sq. ft. of office space for major pension funds. Lowe wants tenants and has accepted short-term, money-losing leases of 15,000 sq. ft. in older buildings in Denver and Austin.

“We've chosen to go for more occupancy because we're not convinced that we've seen rental rates hit bottom,” Best adds.

Stagnating Growth

Best may have a point. Leasing activity isn't likely to improve anytime soon, judging by employment numbers. The Labor Department reports that 465,000 workers lost jobs in February and March. Another 48,000 jobs were lost in April, raising the unemployment rate from 5.8% to 6%.

At the same time, insurance, taxes, security and energy expenses are climbing, and building owners have less leverage to pass through those increases to their tenants. Competition between landlords also is heating up — some landlords are paying higher commissions and giving free vacations to brokers who deliver tenants. In fact, EOP has doubled broker commissions on lease renewals.

So far, such strategies have yet to bear fruit in this cut-throat environment. In the first quarter, EOP's occupancy dropped 350 basis points to 87.2% from 90.7% over the same period a year ago. Meanwhile, EOP's first-quarter earnings fell nearly 30% to $141.7 compared with first-quarter 2002 totals. EOP officials, however, blamed the fall in occupancy on early lease terminations. The nation's largest REIT claims that it's more than halfway toward its leasing goal of 15.5 million sq. ft. for 2003. About 8.7 million sq. ft. has either already been leased or is in the works.

Tenants: More Please

EOP isn't the only landlord trying to nab tenants and maintain occupancy. Service firms in charge of leasing and management for landlords are trotting out a slew of strategies, ranging from convincing building owners to spending millions of dollars on capital improvements or hosting building-wide tenant parties.

Compounding the problem is that landlords were slow to react to deteriorating market conditions, according to leasing experts. When the office downturn first began, landlords tried unsuccessfully to offer tenant improvement dollars and other concessions while still maintaining high rents, says Stephen Schlegel, COO of Jones Lang LaSalle's leasing and management division. But sluggish leasing activity and huge vacancies eventually forced rent rate reductions. “With that kind of scenario in place, most landlords have gotten religion pretty quick,” Schlegel says.

Tenants have little sympathy. In fact, during lease negotiations, they are demanding more free rent, more money for tenant improvements and greater reductions in annual expenses.

Offense: The Best Defense

Undertaking capital improvements at a cost of millions of dollars during a soft market is also a strategy fraught with risk. But owners of older office buildings are often left with no choice, especially as tenants look to upgrade.

The risk paid off at the Lefrak Organization's 750,000 sq. ft. tower at 40 W. 57th Street in New York, which was built in 1972. About two years ago, Lefrak and Insignia/ESG officials started working on a plan to rejuvenate the building. They knew that the market was softening and that 400,000 sq. ft. — or about 53% of the structure — would be vacant by late 2002, says Howard Fiddle, executive managing director of Insignia/ESG's leasing division.

The owners eventually embarked on an extensive $30 million upgrade to renovate the building and avert the impending vacancies. Among other improvements, owners replaced elevators and the HVAC system, re-skinned the exterior, installed new risers, and renovated the lobby.

Last July, Insignia signed Bank of America to a 152,000 sq. ft. lease. The parties declined to discuss the terms. As of early May, building management had reduced the vacancy to 125,000 sq. ft., or 16%, Fiddle claims. “If market conditions were great,” he says, “less than a quarter of that renovation would have been done.”

Keeping What They Got

Newcomers to buildings aren't the only tenants reaping concessions. With leasing agents trying to drum up business, existing tenants are getting more attention than ever, say property managers. These days, property managers and leasing agents routinely contact tenants up to a year before leases expire to discuss lease renewals. During boom times, landlords typically wait for tenants to make the initial contact.

Property managers frequently resort to a simple approach to earn tenants' repeat business. Armed with coffee and donuts, they often pay a visit to tenants just to keep the lines of communication open. Building managers are quick to point out that even in boom times they maintain contact, but clearly they've tweaked those efforts over the last several months. Service firms also host book fairs, ice cream socials or parties to celebrate quasi-holidays such as Cinco de Mayo. “The touchy-feely stuff is what makes a difference,” says Barbara Orton, a senior property manager with Grubb & Ellis.

But don't expect the touchy-feely stuff to continue forever, predicts Fiddle. The tables will eventually turn and landlords will once again have the upper hand.